Fair Market Value - What is FMV and How to Calculate It

Fair market value refers to the price at which an asset could be sold in an open market between two unrelated persons, having reasonable knowledge about the asset and willing to carry out the transaction. Fair market valuation is used extensively under the Income Tax Act, in various situations like gift taxation, transfer of asset for inadequate consideration, Employee Stock Option Plan taxation, and other capital gain situations.  Learn more about its meaning, calculation procedure, valuation methods and examples.

What is Fair Market Value?

• Fair Value or refers to the price set for selling or purchasing an asset in the open market. 
• Financial institutions like NBFCs and Government organizations use Fair Value while assessing the valuation of collateralized or taxed assets.
• Several conditions need to be fulfilled to determine an asset's Fair Value. Buyers and sellers must have full knowledge of an asset before participating in a transaction. 
• Their decision should not be influenced by time or any other external factors. Insurance claims, charity, property taxes, stock ownership, etc., are some transactions requiring this value.

Fair Market Value in Income Tax

Fair Market Value (FMV) is a crucial concept in taxation, especially under the Income Tax Act, and is used to determine the value of an asset for the purpose of calculating capital gains, perquisites, and gifts, among others.

As per Section 2(22B) of the Income Tax Act, the price of capital gains sold on a relevant period in the open market is FMV. If FMV cannot be assessed hypothetically, it is determined using this rule.

Instances where in transaction made not in line with FMV treated in Income Tax laws

• If an individual or HUF receives immovable property or certain movable properties for less than FMV, the difference is taxed as "Income from Other Sources".
• For Employee Stock Option Plans (ESOPs), the FMV on date of exercise is used to compute taxable perquisite value.

How to Calculate the Fair Market Value?

• The calculation of FMV primarily depends on the type of assets. 
• You need to consider some factors while assessing an asset’s Fair Market Value. The uniqueness of an asset, its depreciation status, sales, liquidity, etc., are some factors to look for.
• FMV can be computed by the any of the following bases:
  •  Appraiser’s subjective decision after assessing a specific asset class
  • Considering the asset’s cost to its seller
  • Details of similar objects that have been sold.

Assumptions while calculating Fair Market Value

• The asset is reasonably known to both the buyer and the seller.
• Here both seller and buyer will have their own interest.
• There is no excessive pressure on either party. Each is given a reasonable period for completing the transaction.

Fair Market Value Calculating Method

You can use these five methods for Fair Market Value valuation:

• Selling price

You can evaluate the Fair Market Value of an asset based on information about its recent purchase or sales price. 

For example, you bought a television an year ago for Rs. 75,000. An year later, the same model is sold at RS.60,000. Now, the fair market value should be taken at Rs.60,000, not Rs.75,000. 

• Replacement charges

This method helps you determine the value of purchasing or building an asset or property using a similar asset. It helps you prepare a tax return or file an insurance claim. This method can be used when the asset under consideration is unique in nature and there is limited means for comparison.

For example, a house was constructed for Rs. 80 lakhs, which was destroyed by fire. For constructing a similar house now (replacing it), it will cost about Rs.1 crore. Now, Rs. 1 crore is considered as fair market value.

• Cost of comparable assets

Real estate agents often provide you with a list of sale prices for neighboring homes or properties when you intend to sell a property. This is known as a comparable value. You can determine an asset’s FMV using comparable costs. This is also known as Market Approach.

• Professional opinion

You can hire an expert appraiser to know a property’s valuation. The expert will provide you with your property’s FMV.

There are various provisions in the Income Tax Act which requires a reference by valuation officer for ascertaining the Fair market value of the capital asset, such as determining cost of acquisition in capital gains, transfer pricing and gift taxation.

• Income Approach

The income approach assesses the FMV based on the future cash flows the asset is expected to generate. This method involves discounting these future cash flows to their present value using an appropriate discount rate. This method can also be used if the asset is unique and means for comparison is limited, and significant benefits are expected to flow from the asset.

For example, a machinery is expected to produce goods capable of generating profit of Rs. 10 lakhs every year (adjusted with inflation), for 5 years, then such machinery can be valued at Rs. 50 lakhs 

Fair Market Value of Shares

It is assumed that marketing price data often contains errors. Thus, to assess the normal share price, you need to consider the average trading price of a particular day. Thus, the Fair Market Value of a share is determined by the latest trading price of a publicly-traded company.

Example, If a stock's highest price is Rs. 100 and lowest price is Rs. 95 on a given day what will be the FMV? 

FMV = (Highest Selling Price + Lowest Selling Price) / 2

                  = (Rs. 100 + Rs. 95) / 2 

         FMV   = Rs. 97.50

Significance and Practical Uses of Fair Market Value

• Legal situations: In the event of a divorce settlement or payment of damages due to harm caused to private property, the fair market value of the asset in question is used.
• Taxation: Fair market value is applied in determining the municipal property taxes payable by an owner. Tax deduction is also possible on casualty loss and asset depreciation. For charitable contributions, the fair market value of the contribution is utilized for tax purposes. Thus, a taxpayer can get a tax credit for the fair market value of the contribution given.
• Insurance: Fair market value is also decided in insurance claims. When an insured vehicle is damaged, the insurance claim is relative to the fair market value of the vehicle at the present moment and not what the vehicle was purchased for.
• Property taxes: Local property taxes tend to be based on the FMV of the property owned by the taxpayer. The contrast between the cost of the home and the FMV of the residence can be extreme depending upon how long the owner has owned the house.

Challenges in determining the Fair Market Value

• Comparable data: For specific or unusual assets, it might be challenging to find current, appropriate sales to derive benchmarks. 
• Dynamic economic environment: In the same way, the fast-changing nature of market conditions like economic cycles or unexpected changes in an industry can skew FMV estimates and render trends more difficult to foresee.
• Subjectivity: Various valuators will interpret the same information in different manners, resulting in differing FMV estimates. Intangible value assets such as intellectual property or goodwill also present special valuation issues since the intangible assets do not have concrete reference points.
• Regulatory and legal conditions: Legal requirements also complicate FMV determinations, especially for use in tax or litigation situations where accuracy is absolutely essential. 

Defeating these challenges demands experience, sound analysis, and deliberation about market subtleties to reach a valid and defendable valuation.

Fair Market Value vs Market Value

In Fair Market Value, both buyers and sellers could agree upon a certain price without any influence of external pressure. It generally refers to an asset's current value. Both the sellers and buyers need to agree upon a certain price in the open market to declare the FMV of a particular asset.

However, the demand and supply of a certain product determine its market value. It has little influence on an asset’s current value. Transactions in the stock market usually take place on the market value of the security.

Final Word

Now that you know what is a Fair Market Value and how to assess it, you can determine the FMV of your property, car, and other assets feasibly. However, it is advisable to opt for an expert suggestion while assessing FMV to avoid miscalculations. Professionals remain updated with the recent market trends, so they can help you with accurate figures.

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